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After a week of travelling I came back to see that Moody’s has finally pulled the trigger on the country where I currently reside. This is such a non-story that it feels stupid to even mention but I suppose it will be making headlines for a little while longer. And this is a very good thing.

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

Secondly, I will be referring to my favourite IS/LM model. If you want to read more about it, a very good tutorial can be found here.

So… Let’s assume for a second that the Osborne/Cameron duo is capable of taking a stop-loss on their policy. I know it is a heroic assumption when discussing any politicians but why not…

When looking at record low cost of borrowing, a severely depressed economy and a central bank that does not even pretend anymore to be independent or targeting inflation the recipe should probably be to spend more. In the standard IS/LM model an increase in government spending over taxes (i.e. boosting the deficit) pushes the IS curve to the right. Thus, both the output level and the level of interest rate will increase. Consequently, the exchange rate should appreciate as capital flows to the country in question. This in turn leads to widening of the trade deficit. Ideally, the government would want the Bank of England to step in and limit the increase in interest rates (a.k.a. QE) so that the currency does not appreciate. And, as I mentioned before, the BoE is more than willing to do so.

Let’s now have a look at the situation from another angle. I have been going through he Bank of England’s quarterly reports in reference to trade (which can be found here) and I have found two interesting charts. The first one looks at episodes of rapid moves in the British pound and the impact on the trade balance:

The relationship is pretty strong, which is why many people are calling for debasing of the sterling, particularly after G20 gave a pale-green light to such activities for countries, which are effectively in a liquidity trap.

The second chart shows why debasing of the sterling makes an awful lot of sense. It shows two measures of the International Investment Position – the standard one (i.e. with FDIs at book value) and what I would call a “market” one (i.e. with FDIs at market value).

You can see that the UK is looking quite a bit better if you take into account the actual values of FDIs. I would suggest that the recent rally in global equity prices has at least kept the blue line in the positive territory. This essentially means that GBP devaluation not only boosts the terms of trade but also makes the UK richer. Not very many countries are in such a pleasant situation (think of many emerging economies with significant external debt).

Again, weakening of the sterling does seem to be a very appealing strategy for the authorities. There is, however, one important problem – GBP devaluation is unlikely to bring extra revenues to the government and could actually make the fiscal position a bit worse. Here’s why – devaluing one’s currency and narrowing of a current account deficit means that the country’s savings are increasing in relative terms to investments. Granted, this may well have to happen considering a huge stock of private debt but this is not desirable from the growth point of view. On top of that, the J-curve effect dictates that the initial impact of currency devaluation will be actually adverse.

What I am trying to say is that while GBP devaluation has a lot of positive sides, it will probably not work on its own because it will further depress domestic demand thus putting a strain of public finances.

Therefore, I do believe that Britain has finally cornered itself into a situation where there is overwhelming evidence that Mr Osborne should really start spending. He should also assume that Mr Carney will not let that spending lead to appreciation of Real Effective Exchange Rate (a bit more on that mechanism in one of my previous posts entitled “Be careful what you target or am I in the right church?“). That is to say that the Bank of England will keep nominal and real rates very low. In my opinion this is the only rational way of the situation that we’re currently in. Then again, I am assuming the impossible here, i.e. that the politicians know what the stop-loss is.

How to trade this? I don’t normally trade anything related to the UK (except GBP/PLN) but I would assume that any sell-offs in Gilts should be used as an opportunity to buy. As far as the sterling is concerned, the fact that exports outside of the eurozone are now bigger than to the eurozone, EUR/GBP is a cross that doesn’t make that much sense. I would very much prefer the cable, or better yet selling the sterling against EM currencies as this is where the adjustment in trade balances will have to come from.

So the G20 damp squib is behind us and while many commentators will say that it has given a “pale green” light for the likes of the BoJ to keep devaluing their currencies, I think the whole discussion is somewhat flawed.
Here’s why.
Devaluing one’s way out of trouble seems to be a very convenient solution to most crises. It’s as if producing and selling stuff to other nations was the ultimate reason to live. But devaluation can have many different forms, which some people find confusing.
To explain that let’s actually look at something that hasn’t been discussed for a while, i.e. revaluations and real convergence. It is quite common sense that small, open economies tend to converge to income levels of their richer trade partners. The mechanism usually works through significant inflow of know-how followed by a boost in productivity, particularly in the tradable goods segment. Subsequently, the Balassa-Samuelson effect kicks in and we have a generalised increase in the price level. Usually this is accompanied by appreciation of the currency. Both those factors – higher inflation and a stronger currency – lead to appreciation of the Real Effective Exchange Rate. We have seen such a mechanism in a lot of emerging economies, e.g. in Central and Eastern Europe after the EU entry in 2004.
Note that the two factors at play (nominal exchange rate and inflation) are interchangeable and work together to balance the system. In other words, if for some reason inflation in the country in question is artificially depressed, the nominal exchange rate will move more.
Now let’s go back to devaluations. There are two broad reasons why a country would like to weaken its currency:
1) to boost exports,
2) to increase the money supply.
This distinction matters because without that how could we explain behaviour of such countries as Japan, Switzerland, Czech Republic or Israel? These economies have traditionally excelled at exports due to superior growth rates in productivity in the tradable goods sector. Yet, those countries have engaged in significant operations in the foreign exchange market in recent years (or threatened to do so). Note, however, that in each and every case it was preceded by bringing interest rates close to zero. Therefore, we should conclude that FX operations were just an extension of monetary policy after traditional ways (i.e. interest rate cuts) have been depleted. As a result, saying that these central bank have engaged in currency wars is pretty daft, in my opinion.
Now, there is a group of countries, which probably would like to see their currencies weaken to improve the competitiveness. However, if this is an objective then we must discuss the real exchange rate. And the standard economic theory dictates that it can only be done via increase in government savings.
Let’s take the most recent example of a country, which seems to be trying to pursue such a goal. The Central Bank of the Republic of Turkey has been stressing the importance of the REER lately. They even outright threatened that they would intervene in the FX market should the 120 level be broken. There is a fundamental flaw in this logic, though.
To start with, Turkey is a country with a very high current account deficit, which basically means that its domestic savings are relatively low. By extension, consumption is fairly high thus keeping inflation rather elevated. In such an environment, selling the lira (TRY) makes very little sense as it will most likely boost inflation even further, offsetting the paper (aka nominal) gains. This brings us to a paradox that higher inflation leads to higher REER thus necessitating monetary policy easing. In my home country of Poland we have a saying that “they can hear a bell toll, they just don’t know at which church”. Similarly here – the CBRT has correctly identified the problem of having to boost competitiveness but they have chosen a dangerous approach.
Instead, the government should increase its savings even more than it already has to bring total domestic savings higher, thus increasing competitiveness. This way, it can avoid persistently high inflation and current account deficits.
This is not to say that such a recipe is great for everyone. It would’ve been good for, say, Spain before the crisis but now the focus should be more on the nominal side of the equation. Such examples could be multiplied.
But what I’m trying to say is beware of people talking about currency wars any time they see a central bank intervening in the FX market because you will miss the important distinction between the nominal and the real sides of things.
And policymakers, be careful what you target because you can end up at a wrong church.

PS. I wrote this post on “yet another on time Ryanair flight” so there are no links or anything. I will try to update those tomorrow with a few interesting articles on the subject.